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Monday, April 07, 2008

Never send a man to do a machine's job

Chapter 5 of the MIFC report talks about algorithmic trading and the potential for India to achieve a role in international finance here. Direct market access was prohibited by SEBI and hence this kind of development could not take place. Algorithmic trading also figures on page 152 of this report on the policy aspects of OTC vs. exchange-traded paths to organised financial trading.

SEBI has removed this constraint, and shifted to the conventional stance of securities regulators worldwide on this question. Here is the SEBI circular, and here is good reportage in Mint by Mobis Philipose, Rachna Monga and Khusbhoo Narayan.

With this, we get one more tick on the checklist of activities on implementation of the MIFC report. An edit in Business Standard says:

The Securities and Exchange Board of India (Sebi) has removed the regulatory impediments that prevented securities firms and their clients from directly connecting their computers to the stock exchanges and automating trading strategies. India has already evolved a highly computer-intensive stock market. Order placement, order matching, risk management, payment and settlement are all fully computerised. The Luddite rule which prevented a role for computers in the actual trading process, was an incongruity. Removing it made sense.

The automation of trading strategies, termed algorithmic trading or AT, helps increase the efficiency of a large number of mundane processes of the financial markets. When a security trades at multiple venues, such as NSE vs BSE, or spot vs. futures, there must naturally be a very tight link between prices at these multiple venues. At present, this link is established by virtue of human arbitrageurs, who watch two screens and look for arbitrage opportunities. Computers excel at patiently watching for these, making no mistakes in calculations or order placement. Further, dedicating one or two employees to watch a related group of securities is expensive and tends to be done only for the biggest securities, such as Nifty shares. With computerisation, it becomes possible to monitor smaller stocks, thus permeating greater liquidity and pricing efficiency for a bigger range of stocks. Once the algorithms start flourishing, it would increase Mumbai's attraction for listings from firms outside the country.

Interest rates and currencies are natural areas where AT can play a big role, given the simple formulas that are involved in yield curve or currency arbitrage. However, deriving these benefits requires first shifting the bond market and the currency market to electronic exchanges.

Outside India, tens of thousands of capable finance professionals are engaged in the development and implementation of such trading strategies. This process has not begun in India because such computerisation was banned. Hence, Indian financial firms are inexperienced and will need to rapidly catch up. Goldman Sachs and J. P. Morgan have in-house knowledge on AT, which can be applied to Indian exchanges. Indian financial firms such as ICICI Bank, HDFC and UTI need to set up R&D teams which set about matching global expertise in this.

The report on Mumbai as an International Financial Centre has emphasised that the field of AT unlike many other elements of finance is one in which India can make its mark. It requires brainpower and not human relationships. Individuals of Indian origin are already prominent in such work at global financial firms, while being located in London or New York. An R&D team sitting in Mumbai is well equipped to compete with one placed in London or New York. Hence, Mumbai could become a centre of AT activity, with thousands of individuals developing the specialised knowledge of computer engineering, statistics and financial economics that is required to build these systems. Building such systems for deployment with Indian exchanges is the natural stepping stone through which these individuals and teams will graduate to doing such work for the international market.

Ranked by the number of transactions, the top two exchanges of the world are Nasdaq and NYSE. India's premier exchanges, NSE and BSE, are ranked third and fifth, respectively. AT is estimated to account for as much as half the business of Nasdaq and NYSE. Sebi's move could, thus, pave the way for NSE and BSE to gain in the global league table.

5 comments:

DMA will be good, and it should also be allowed for individual investors (though we do have some form of access in the ODIN style terminals). Why, it's not only the institutions that can write automated trading strategies - individuals like me would also want to (and the returns make sense to individuals who only have to compete with a bank deposit - insti returns are judged at much higher).

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